For a few weeks now, I have mentioned the January fixed income rally that we have seen the past three years. If you count this year, that would be four years in a row. You can see from the chart on the right how strong this pattern has been. We have averaged a surprisingly consistent 40bp drop in yield the previous three Januarys. For comparison purposes, I adjusted the previous years’ rates on Jan 1 (and subsequent rates) to this year’s Jan 1 rate (2.45%).
I generally don’t have a strong view on seasonal patterns. One would think that with efficient markets, there should be an adjustment (eventually). What makes the January fixed income rallies a little suspicious is that in some of those years, the data was not particularly bullish. For example, this year’s data has been slightly stronger (with both GDPNow and Nowcast up slightly since year-end). 2015 was not weak. 2014 and 2016 Q1 GDPs were very low (-1.2% and 0.8% respectively), so I suppose a small part of the rally could be some kind of Q1 seasonal data play. But the 2014 was mostly weather-related and we bounced back strongly in Q2 and Q3.
It’s not clear if part of this rally is structural. It’s possible that because many of the larger market players have a January through December trading year, we could get larger than-usual demand for carry trades at the start of the trading year. After all, with a “gradual” Fed, the post-Great Recession interest rate behavior, and even the 35 year bond downtrend, it is not unreasonable to want some carry income. People may be looking more at carry-adjusted charts. Most younger traders have probably never seen a real bear market and have generally done well buying on dips. In fact, you probably could have built a long career on being just long fixed income carry.
I want to put on some outright bearish positions for fiscal stimulus as much as the next guy. There are less than two hikes priced in for 2018, after all. That seems low. But when (1) the positioning shows that most of the market is STILL bearish, and (2) we have Article 50 coming up, and (3) I have a sneaking suspicion that there was overhiring for the holidays last year (which means overfiring post-holidays), and (4) the prospects of a Trump/China/Russia negative headline is elevated, my plan is to be patient. I am going to want to be cautious until at least until two of these factors goes away, possibly even going into February.
I like the following two-pronged plan:
- Accumulate bullish tail protection. This is going to make us more comfortable through any month-long rally, especially if we want to add some outright bearish trades. Some options structures look very cheap.
- Accumulate some more “protected” bearish plays the rest of the month. The reason I put the line for 2013 in the chart on the previous page is just to show that the January fixed income rally is not written in stone. So we should be prepared for other scenarios. Depending on the tone of the data, the news and the markets, we could think about dipping more than a toe into 2018 hikes at some point in the next few weeks.
We have already started accumulating both of the above categories of trades on the Trade List, but we should look for some additional opportunities.